Deal Terms in Real Estate Syndications

While the specific types of securities commonly offered to investors in real estate syndications vary depending on the issuer’s organizational structure,  in general, investors are typically offered some form of equity based securities. In the context of an LLC, for example, depending on whether the LLC is member-managed or manager-managed, investors are commonly offered a specified “class” of membership interests that entitle investors to preferential distributions of cash but with limited voting or managerial authority.

In a member-managed LLC, the sponsor group would retain a different class of membership interests than the investors, which typically entitle its holders to cash distributions but typically only after the investor class receives distributions up to a stated threshold, and the sponsor’s class of interests would entitle its holders to subordinated economic rights.

In a manger-managed limited liability context, it is common for the issuer to still designate two different classes of membership interests, one for the investors and one for the manager, to memorialize the preferential cash distributions to the investor group. The main difference, however, would be that the interests reserved for the sponsor group would normally come with limited voting and managerial authority, and instead the operating agreement would designate a manager with the authority manage the company.

This structure is similar in the context of a limited partnership, where investors would be offered limited partnership interests that would entitle its holders to preferential distributions of cash, while the sponsor group would hold general partnership interests that entitled its holders to distributions of cash, but again, only after the LPs receives distributions up to a stated threshold. It is important to emphasize that, where the distribution of voting and managerial authority may be specified in the limited partnership’s limited partnership agreement similar to how it would be specified in an LLC’s operating agreement (i.e., vested in the general partner or manager, as applicable), investors risk becoming considered general partners in a limited partnership if they participate too heavily in the limited partnership’s decision making process.

Determining whether the terms of a real estate syndication meet or exceed market standards is, as one would expect, a deal-specific exercise that involves a comprehensive market analysis. That said, there are some considerations that can help sponsors assess the reasonableness of their offering terms.

For one, sponsors should review materials of similar real estate syndications in the sponsor’s target market. In particular, sponsors should look for deal terms of real estate syndications that involve a similar type of property in a similar or the same locale with a similar sized offering, investment structure and risk profile. Sponsors should pay special attention to minimum investment amounts, projected returns, fees and project duration. When considering project returns, for example, sponsors should compare to the expect returns of similar investments in the market and assess whether the projected cash flow, appreciation potential and overall return on investment are competitive. When reviewing these terms, sponsors should ask themselves whether their terms align with those of other real estate syndications in their market.

Sponsors should also avail themselves of current trends in the real estate syndication market, including monitoring the performance of comparable properties, vacancy rates, rental rates, and overall demand for real estate investments in the target area. Understanding market conditions will help sponsors gauge investor expectations.

As alluded to in the FAQ titled “What types of securities are commonly offered to investors in real estate syndications?”, regardless of the type of security offered in a real estate syndication, investors typically retain limited voting rights. The scope of voting rights may vary depending on the complexities of the real estate syndication structure, however, investors will typically only be able to vote on actions that have a material impact on their economic position within the company. For example, most investors are typically entitled to vote on actions that are outside the scope of the ordinary course of business of the issuer, or to make substantive amendments to the real estate syndication vehicle’s governing document (i.e., its operating agreement if an LLC or limited partnership agreement if a limited partnership). Investors are also commonly entitled to vote to require the sponsor (i.e., the manager or general partner) to cure any sort of misconduct and/or remove the manager if it fails to cure its misconduct (depending on the terms of the vehicle’s governing document), and to cause the real estate syndication vehicle to liquidate or dissolve. Notably, however, investors are almost never entitled to vote on general managerial actions or actions required in the ordinary course of business, as those matters are reserved for the manager.

While it is most common for real estate syndication vehicles to designate two classes of ownership with one class reserved for the investor group and one class reserved for the manager group (as described in the FAQ titled “What types of securities are commonly offered to investors in real estate syndications?”), there are no restrictions on the number of classes of ownership that may designated by a real estate syndication, and depending on the sponsor’s intentions and the complexities of the deal, it may be in the sponsor’s best interest to designate a third class (or even further additional classes) of ownership for special groupings of investors. Some illustrative examples of scenarios that give rise to multi-class structures include:

• Instances where a certain investors contribute a significantly greater amount of capital and are offered preferential economic terms;
• Instances where early investors are offered preferential economics;
• Instances where different classes of investors are associated with differing investment terms; or
• Multi-asset structures where investors choose into which asset they seek exposure based on class.

There are a variety of fees that sponsors commonly charge in a real estate syndication, however, all such fees are generally proportional to the sponsor’s efforts in performing certain services on behalf of the real estate syndication.

For example, sponsors often charge a one to two percent “asset management fee” for their efforts in overseeing and managing the real estate syndication vehicle generally. The asset management fee can be based on a variety of metrics, most commonly the total capital contributions of the real estate syndication vehicle, its gross annual income, or its net asset value. The asset management fee is also typically a recurring fee, earned periodically (i.e., monthly, quarterly, bi-annually or annually).

Sponsors also often charge an “acquisition fee” for their efforts in performing due diligence on the real estate syndication’s target property or properties. The acquisition fee is typically based on the purchase price of the applicable property or properties and is a one-time fee paid at the closing of the property or properties.

Sponsors also sometimes charge a “disposition fee” for its efforts in marketing the target property or properties for eventual sale, which is also a one-time fee paid upon the sale of the property or properties.

In addition, if the sponsor finances the acquisition of the target property or properties with the goal of eventually refinancing, sponsors sometimes charge a “refinance fee” for its efforts in obtaining a refinance loan on the property or properties, which is typically a one-time fee and based on the amount of the new loan.

Lastly, depending on whether the real estate syndication vehicle engages any third-party service providers that may be affiliated with the sponsor, such as affiliated construction management or property management companies, the sponsor’s affiliates may also charge fees relating to those services at market rate.

When structuring the distribution waterfall for a real estate syndication, it is important at the outset to ensure that the distribution waterfall is designed so that it aligns with the interests of both the sponsor and the investors. Moreover, there are typically multiple waterfalls in the issuer’s governance document: the distribution waterfall during operations, the distribution waterfall upon a capital transaction, and the distribution waterfall in liquidation.

To that end, the first step in the issuer’s distribution waterfall during operations or upon a capital transaction is almost always some sort of preferred return hurdle or internal rate of return (“IRR”) hurdle for the investor class of securities. Notably, the primary difference between a preferred return hurdle and an IRR hurdle is that a preferred return hurdle’s unpaid preferred return will accrue but not compound (unless stated otherwise), while an IRR hurdle’s unpaid preferred return will accrue and compound. In either case, this first step allows for the investor to receive a minimum annual return before the sponsor receives any distributable cash. A common preferred return hurdle or IRR hurdle is in the 6%-10% per year range.

The next step in a distribution waterfall upon a capital transaction, after the preferred return hurdle or IRR hurdle is achieved, is to ensure that investors receive a return of their initial capital contributions. This step involves the issuer’s return of each investor’s initial capital contribution before cash is distributed further.

Finally, in a distribution waterfall upon a capital transaction once the investors have achieved their preferred return hurdle or IRR hurdle and received a return of their initial capital contributions, the sponsor may be entitled to a share of the profits. This portion of the flow of cash distributions is often referred to as the “promote,” and typically consists of distributing a percentage of the remaining profits after accounting for the preferred return and return of capital to the sponsor. Common promote percentages range from ten to forty percent of distributable cash, depending on the specific deal and investor appetite, with the remaining distributable cash distributed pro rata among the investors.

Notably, in some cases, a “catch-up” provision may be included in a waterfall structure to allow the sponsor to “catch-up” to receive a greater percentage of profits until a predetermined percentage of total profits has been met. After the catch-up threshold is met, subsequent profits are then distributed pro rata.

It is important to note that the specific structure of a cash distribution waterfall can vary greatly depending on the deal terms, negotiations with investors, and the unique characteristics of the real estate syndication. The above steps can be modified in a variety of ways and is only a general representation of a typical, straightforward distribution waterfall.

While the allocation of offering proceeds can vary depending on the target property or properties and the sponsor’s general investment strategy, the primary use of proceeds is almost always be for the down payment/acquisition of the target property or properties. Beyond using proceeds for the down payment/acquisition of the target property or properties, remaining proceeds should be allocated as needed toward costs and expenses relating to legal/organizational expenses, paying the sponsor its acquisition fee (if applicable), closing costs related to the acquisition of the target property or properties, a construction or renovation budget (if applicable), costs relating to third-party services and, if available, creating a cash reserve for working capital. Sponsors should be mindful of their anticipated costs through the full length of the project timeline when determining their target and maximum offering amounts so that there is ample room to allocate of offering proceeds where needed.

If the sponsor of a real estate syndication finds that it still needs additional capital after having already conducted a round of capital raising, there are several options the sponsor can consider.

For one, if the possibility of needing to raise additional capital in the future was already contemplated by the sponsor and accounted for in the real estate syndication’s offering and corporate materials, the sponsor may issue a request for additional capital from existing investors in proportion to their initial capital contributions, otherwise known as a “capital call.” While the terms and conditions applicable to capital calls would need to be specifically outlined in the issuer’s offering and corporate materials, a capital call can be made to require investors to contribute more capital on an as needed basis.

A second alternative sponsors can explore is to initiate a new capital raise from new investors. Provided that the issuer’s manager and/or members consent to the capital raise, corporate documents allow it raise additional capital, the sponsor may either offer a new class of equity securities or offer the same class of equity securities as previously offered. Notably, while, depending on the terms of the issuer’s governing document(s), designation of a new class of equity securities may require certain action be taken by the issuer’s manager and/or members, as the sale of the new class of equity would likely dilute existing investors unless they participate in the new offering pro rata.

Finally, sponsors may also seek to refinance the real estate syndication’s property or properties or obtain additional debt financing, as described in the FAQ titled “Introduction to using debt to finance real estate transactions”.

It is not uncommon for real estate syndication sponsors to leverage debt financing as a tool to fund their real estate transactions rather than taking on no debt and only funding their real estate transactions with cash from investors and the sponsor group.

In general, debt financing allows sponsors to borrow funds from lenders or financial institutions to optimize the real estate syndication’s capital structure and maximize potential returns for investors. For example, debt financing allows sponsors to increase their purchasing power by leveraging a small portion of their own capital in exchange for the loan, allowing the real estate syndication vehicle to acquire more desirable target properties that it otherwise could not. In addition, if the income generated from operation of the target property exceeds the cost of servicing the debt, the leverage effect can significantly boost overall investment returns. Further, debt financing allows sponsors to diversify their sources of capital, thereby giving sponsors the flexibility to allocate their own capital to other operational needs.

That said, there are also some key considerations sponsors should keep in mind when considering using debt. For one, sponsors must ensure that the real estate syndication vehicle’s property cash flow is sufficient to cover the debt service obligations, including principal and interest payments. An analysis of the property’s income potential and expenses is critical to assessing its ability to generate adequate cash flow. In addition, evaluating loan terms, interest rates and repayment periods is essential. Sponsors should compare offers from multiple lenders to secure the most favorable terms possible that align with their investment strategy and projected returns. Further, maintaining a healthy debt-to-equity ratio is important to striking a balance between leveraging the investment and maintaining financial stability. Sponsors should consider the appropriate level of leverage based on factors such as market conditions, property type, risk profile and investor preference. Debt financing also often involves certain loan covenants (i.e., conditions that borrowers must adhere to), such as requiring any equity owner of twenty percent or more of the borrower’s equity stack to sign any loan documents. Sponsors should carefully review and understand the lender’s terms and the real estate syndication’s investor composition when determining the appropriateness of a lender’s offer.